Thoughts through the cycle: W3 January ’20

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Central Banks

  • In developed economies, the central bank mantra with respect to inflation is usually a target of at or around 2% in the medium term. It was not always so. The mandates of central banks generally refer to price stability rather than a specific target level of inflation. Inflation-targeting was in fact first enacted as a policy goal by the Reserve Bank of New Zealand in 1990, with other central banks subsequently adopting it.

  • Markets in general and those in the US in particular love the ‘goldilocks’ combination of solid growth, rising corporate earnings, and moderate yet steady inflation. With an accommodative US Federal Reserve and hopes of a rebound in trade given the imminent inking of Phase 1 of the Sino-US trade deal, it is probably a good time to examine inflationary trends in the context of the currently-anticipated global recovery.

  • Inflation refers to the change in prices on a year-on-year basis. As a rate of change calculation, the point of comparison is usually price levels from the previous year, referred to as base effects. Despite the enormous money-printing efforts of global central banks since the global financial crisis (and the periodic fears of stoking inflation epidemics this causes in markets), inflation expectations have remained relatively close to the stated 2% central bank targets.

  • The graph below shows three different measures of long term inflation. Aside from the financial crisis, there has been a general downward trend in inflation since the 1980s. The red line shows the University of Michigan 5-10 yr consumer survey view of inflation. The blue line shows a 10yr zero coupon swap, and the yellow line shows the inflation breakeven for 10yr UST TIPS (inflation-linked bonds). These are all effectively market measures of inflation.

Source: Bloomberg, 13 January 2020

  • Why is it that with all this central bank ‘money printing’ we have seen no rise in inflation? Part of the answer lies in the manner of the printing. In its first two periods of quantitative easing (QE), the US Federal Reserve bought treasuries and mortgage-backed securities (MBS) in the open market from asset managers and the like. This not only forced down yields, but also reduced the stock of such securities available for wider ownership, forcing asset managers to buy longer-dated and higher-yielding (riskier) assets to replace them. The important point is that the money stayed within the financial and financialised system, and did not find its way into people’s pockets to spend on goods and services.

  • In the US, another key feature has been the somewhat chicken-and-egg situation of low growth and low real rates dissuading corporates from making heavy investments in capital expenditure and R&D but instead filling the void with (cheap) labour. The intertwined themes of globalisation, an aging population, declining union power, and technological advances (notably automation) has kept a lid on US wages, which in turn has moderated inflation and inflation expectations.

  • The Fed’s favoured metric of inflation is the PCE deflator, currently measuring 1.5% as of November 2019 (see graph below). Given the Fed’s target of a 2% inflation and the willingness to run the economy hot in order to catch-up on the current period of below-target inflation, much of the Fed’s continued dovish tone in 2019 can be explained by how moderate inflation has been so far.

Source: Bloomberg, 13 January 2020

  • One observation that emerges from this brief discussion is that any examination of inflation depends on which metric one uses to measure it, and that is itself ultimately a question of what components are used in that particular metric and what weighting those components hold within that particular inflation basket.

  • The PCE deflator used by the Fed does not weight healthcare costs to a signficant degree. The Bureau of Labour Statistics (BLS) graph below shows healthcare costs growing at 5-10% in 2019, far in excess of the 1.5% core inflation level assumed by the Fed. Bear in mind that healthcare amounts to almost 20% of US GDP at present when one considers the magnitude of these cost increases. Taken with rising rents and student loan costs (all considered ‘burden’ rather than ‘discretionary’ consumer spending), a picture starts to emerge of much higher inflation in certain areas of US economic life which are not necessarily represented in the statistics used by the Fed. The rise of populism and general social dissatisfation in the US can in no small part be explained by statistics such as these.

Source: U.S. Bureau of Labor Statistics January 2015 – January 2020

  • What of wages and inflation? The Phillips curve has historically been treated as a measure of how wage inflation feeds through to wider inflation in the economy. With an aging population, off-shoring due to globalisation, and automation in factories and warehouses, wage pressures have remained subdued during the current cycle.

  • The most recent BLS data for US wage growth for December 2019 (graph below) shows that wage pressures continue to abate, even with unemployment at historically low levels of 3.5%. Wages and inflation tend to peak at the end of the economic cycle, so trends in both ought to be watched closely, especially if wage growth is starting to roll over.

Source: Bloomberg, 13 January 2020

  • Why does all this matter? At present, the Fed has stated that any changes to its policy rate will only be the result of a major change in market conditions (in either direction). The graph below shows 10yr UST real rates (blue line) and 10yr implied inflation from zero-coupon swaps (red line). The Fed, through forward guidance and T-Bill purchases is keeping a lid on real rates (blue line), while market hopes of reflation are being reflected in rising inflation expectations (red line).

Source: Bloomberg, 13 January 2020

  • If this pattern continues (low real rates, rising inflation) the US economy may find itself in a position similar to that of the 1970s of stagflation (inflation without real economic growth). Should wage inflation continue to attenuate and overall inflation expectations resume their decline to the backdrop of a low real-rate, low growth environment, then the spectre of debt-deflation Japanese-style could raise its head.

  • The critical consideration here is the stock of debt, at a government, corporate, and household level. The 1970s was a period of high inflation but low leverage in the US (especially relative to now). The question of how rising inflation would affect the cost of credit, and how this would feed through into both consumption and the corporate debt-for-equity swap (buyback) are key. If inflation expectations continue to trend below target, the question of whether debt burdens can be serviced in a low-growth, falling-earnings environment becomes the operative one.

Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 14 January 2020.

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